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Remarks at the Council on Foreign Relations' C. Peter McColough Roundtable Series on International Economics, New York City

It is a pleasure to be here at the Council on Foreign Relations, and to be here
with Jerry Corrigan.

A few brief remarks about the global economy, both the real and financial dimensions,
to provide a basis for our discussion.

2006 marked the fourth successive year of a global expansion that has been remarkable
for its strength, for its breadth, and for its stability in the face of economic
shocks and uncertainty in the geopolitical realm.

This period of broad-based growth in income has been supported by a number of
important fundamental forces.

Rapid technological innovation and greater economic integration have brought
stronger growth and higher levels of productivity. The acceleration in productivity
growth that occurred in the United States in the second half of the last decade
seems likely to remain intact. And productivity growth is accelerating outside
the United States, most strikingly in some of the large emerging economies.

Financial innovation and greater integration of national financial systems has
contributed to the strength of real economic activity by improving the allocation
of resources within and among economies. Improvements to risk management and
to capital cushions are likely to have made the financial system more stable
and more resilient.

And macroeconomic policy has improved around the world. The increase in monetary
policy credibility in a broad range of countries has produced lower rates of
inflation and more stability in inflation expectations. Greater public confidence
in monetary policy was critical to laying the foundation for the improvements
in real economic performance, by providing a stable foundation for long-term
investment decisions.

In emerging markets, better monetary policy has been accompanied by more disciplined
and conservative fiscal policy and a range of other policies that have reduced,
though not eliminated, vulnerability to changes in confidence, capital flows
and exchange rate movements.

These factors are each fundamentally important, and they are, of course, interrelated.
The policies that delivered better inflation outcomes, more openness and competition
and stronger financial systems were critical to fostering an environment in
which improvements in productivity and growth could occur.

This expansion has also been notable for the financial conditions that have
prevailed over the past several years.

Long-term interest rates have remained relatively low in nominal and real terms.
Equity and other asset prices have moved higher. Credit spreads have declined
to quite low levels. Market participants report exceptionally high levels of
liquidity. And volatility, both realized and expected, has remained low across
many different types of financial assets, market and economies.

This general constellation of market conditions and asset prices is unusual,
at least in comparison to what we have seen over the past several decades. This
has been a distinguishing feature of the present expansion, but it is not something
we fully understand, and we cannot be confident in judgments about how durable
it will prove to be.

To a significant extent, these financial developments reflect a high degree
of confidence in future macroeconomic and financial stability, reinforced by
the improvements in inflation performance, growth outcomes and financial resilience
of the past several years.

Better monetary policy has lowered expectations of future inflation and inflation
volatility and has contributed to lower risk premiums in general. Changes in
the cyclical behavior of financial intermediation and credit provision, coupled
with the increased stability of the real economy, seem likely to have reinforced
the improvements on the monetary policy front.

And rapid growth in the major emerging market economies, together with the substantial
earnings of energy-producing and commodity-exporting countries, have produced
a substantial increase in wealth and savings relative to perceived investment
opportunities. In a world where capital can now flow much more freely across
national borders, a significant portion of these savings has moved across national
borders.

These are powerful and fundamental forces, and they certainly help explain the
broad reduction in risk premiums and the substantial demand for credit risk
and financial assets.

There are other factors at work as well, however, that have less favorable implications.
Part of this recent dynamic in financial markets is a consequence of the present
state of the international monetary system, in which a substantial part of the
world economy runs exchange rate regimes tied in some way to the dollar. This
has entailed a sustained period of very substantial official accumulation of
dollar reserves, putting downward pressure on U.S. interest rates and upward
pressure on U.S. asset prices.

These forces are surely transitory, but their impact on capital flows, interest
rates and asset prices are important, not just in terms of their short-term
impact on growth. If they are large enough, they have the potential to alter
or distort current decisions about investment and consumption in a way that
could be detrimental to our longer-run growth prospects. And they are important
because they work to mask or dampen the effects on risk premiums in financial
markets that we might otherwise expect to be associated with the expected trajectory
of the fiscal and external imbalances in the United States.

Given this broad context, I want to touch briefly on some of the policy issues
that are likely to be important to the prospects for economic performance, here
and around the world. Despite the relatively favorable performance of the global
economy, we face a range of daunting longer-term economic policy challenges.
The improvements in the conduct of monetary policy were critical to the improvements
in productivity and growth that we are now seeing on a global scale. And monetary
policy will, of course, continue to be critical, but monetary policy alone cannot
provide the elements of the framework necessary to provide an environment for
innovation and long-term decisions that will be so vital for future growth.
Economic policy, in general, needs to be more forward looking in providing a
longer-term framework for stability.

On the fiscal policy front, demographic changes confront governments around
the world with exceptionally difficult choices. For the United States, these
challenges are less acute than for many of the major economies, but they are
still formidable in their scale and complexity. Even for the near term—for the period before the increase in number of retirees starts to have a major
impact on Social Security and Medicare expenditures—we are running an
unsustainably large fiscal deficit. Despite the recent improvements in revenues,
the expected trajectory for the fiscal deficit will mean that federal government
debt will continue to rise as a share of GDP. The restoration of fiscal rules—such as those that require new tax cuts or expenditure programs to be
funded with offsetting policy measures—will help reduce the risk of
further deterioration. However, they need to be complemented by a consensus
on policy changes that will produce smaller future deficits.

Restoring confidence in U.S. fiscal management would be important and necessary
independent of the broader context of the global economy today, but it is more
important given the size of our external imbalance, now running at the unprecedented
level of 7 percent of GDP a year. The trade balance in real terms has been broadly
stable over the past two years, but our net income payments have shifted to
deficit, and the size of that component of the current account deficit seems
likely to continue to expand. These large global imbalances, our current account
deficit and the surpluses that are the counterpart to our deficit, will have
to come down over time. How that process unfolds will depend on a complex mix
of factors around the world. Confidence that the U.S. political system will
act to generate a sustainable fiscal trajectory is important to raising the
probability that this process of adjustment unfolds with less risk.

A successful conclusion of the Doha round of trade negotiations would provide
some insurance against the risk that the process of economic integration will
be interrupted or reversed. Despite the relatively favorable average income
gains of the past few years, a common feature of the political context in economies
around the world is the fragility or weakness of public support for openness
and economic integration.

The political challenge of sustaining support for the process of integration
may be the most important economic challenge of our time. To paraphrase Lawrence
Summers, it is not enough to explain that globalization is inevitable and that
policies that look politically attractive as a response to economic anxiety
will only hurt the economy as a whole. Nor is it a politically effective strategy
to state simply that economic integration is a necessary and powerful force
in raising average incomes, or that technological change may be more important
than trade or immigration as an explanation for slower growth in real wages
for many Americans.

Raising the quality of education and exploring ways to improve the safety net
are a necessary part of the solution to this challenge. But these reforms will
have a long fuse and they may not yield the hoped-for increase in support. Trade
does not appear to be more popular in countries with more generous safety nets,
universal health care and highly subsidized higher education than it is today
in the United States.

The political challenges of sustaining support for global economic integration
and fiscal sustainability will be more difficult in the United States because
of what has happened to the distribution of income and economic insecurity.
Several broad economic forces substantially complicate an already difficult
set of political challenges: the long-term increase in income inequality, the
slow pace of growth in real wages for the middle quintiles of the population,
the increase in the volatility of income that is a reflection of the greater
flexibility of the U.S. economy, and the greater exposure of households to the
risk in financing retirement and the burden of paying for health care.

More generally, the global financial system and the monetary arrangements that
underpin it are in the process of a delicate and consequential transition as
the major emerging market economies—particularly in Asia—move
toward more mature monetary policy frameworks, more flexible exchange rate regimes
and more open capital markets. This transition will require careful management,
and the economic dimensions of getting it right would be complicated even without
the political pressures those governments face.

One final note on the financial system. The global financial system is in the
process of very dramatic change. The changes of even just the last five years
are extraordinary, in terms of the size, and strength, and scope of the major
global firms, the role of private leveraged funds, the extent of risk transfer
and the increase in the size of the derivatives market, the change in the structure
of the credit market, the increase in and changes in the pattern of cross border
financial flows.

These changes, and others, seem likely to have made the financial system both
more effective in moving capital to its most productive use and more stable
and resilient over time. But they do not, of course, mean the end of systemic
risk in financial markets. They could in some circumstances work to magnify
rather than mitigate stress. Central banks, supervisors and those running the
major private financial institutions need to continue to work to ensure that
what Jerry Corrigan calls the “shock absorbers” in the financial
system—capital and liquidity and the operational infrastructure—are sufficiently strong and robust to withstand economic and financial conditions
more adverse than we have seen in the recent past.